Spain to ECB: Inflate or Die

The Bane of Europe

“Thou hast seen nothing yet.” – Miguel de Cervantes, Don Quixote

In the late 15th century, the gods look down from the heavens above and smiled upon Spain. With the capture of the Emirate of Granada in 1492, Spain completed the Reconquista of the Iberian Peninsula…ending the last remnant of a 781-year presence of Islamic rule. That same year, in a voyage funded by Queen Isabella, Christopher Columbus discovered the new world.

Soon after, Spain emerged as the first world power.

For the next 200-years Spanish treasure fleets transported vast riches of gold, silver, spices, tobacco, and agricultural goods, from the Spanish Empire in the Americas to the homeland. Spanish rulers just knew their good fortune was limitless and without end. But alas, the bounty was not without consequences.

Overtime the flow of wealth to Spain became an expected entitlement. The influx of riches proved not to be a blessing, but a curse. Like spoiled heirs of a family fortune, or an unprepared lottery winner, Spain squandered its wealth through a succession of misadventures.

Wars of succession, Hapsburg inbreeding resulting in the grotesque Hapsburg Chin, Napoleonic rule, Spanish-American War, Civil War, and much more, drained Spain’s resources and undermined their empire. By the late-17th century Spain had fallen into irreversible decline and for the next 250-years was the bane of Europe.

Golden Opportunity for Ruin

At the dawn of the new millennium the gods were finally smiling down upon Spain again. On January 1, 2002, Spaniards traded in their pesetas for euros. Seemingly overnight, Spanish bonds were priced at about par with German bunds…kicking off an economic boom.

In no time at all, euphoric images of limitless wealth returned to the Iberian Peninsula. Not since Spanish Galleons loaded to the hilt with gold filled the Cadiz harbor had the population of Spain been so jubilant. Moreover, not since Hernan Cortes toppled the Aztec Empire had Spaniards been granted such a golden opportunity to ruin themselves.

Like most nations during the first decade of the 21st century, Spain made a mess of things with an epic and enthusiastic property mania. Then, as property prices reached extraordinary heights, foreign trade deficits exploded too. Strangely, after all the years of economic flailing, Spain wasn’t suspicious of the flood of cheap money or the speculative intoxication that followed.

Things were just wonderful in Spain until just the moment they weren’t. That’s when, in 2008, a severe property led recession crashed on its shores. Astonishingly, unemployment spiked from 7.6 percent in October 2006 to 22.8 percent at the end of 2011. But that’s not the half of it…

Spain to ECB: Inflate or Die

Last week, for instance, yields on 10-year Spanish bonds climbed to 5.84 percent…their highest rate since the European Central Bank started flooding Europe’s financial system with liquidity last December. Yet, even with the higher rate of a payment, Spain was only able to sell 2.59 billion euros of debt, far short of its maximum target of 3.5 billion euros.

Like Greece, Spain is broke. However, unlike Greece, Spain’s economy is too large for the ECB to bailout without severely undermining the euro.

Spain’s GDP, based on 2010 data, is $1.4 trillion. This amounts to nearly double the GDP of Greece, Ireland, and Portugal combined. Additionally, Spain’s GDP amounts to 8.6-percent of the entire Eurozone’s GDP. A bailout of that magnitude could cause serious problems for the euro. But what choice does the ECB have…

As Spain has shown, the ECB’s current long term refinancing operation (LTRO) may not be enough to backstop the European financial system. Following Spain’s lackluster bond auction ECB President, Mario Draghi, surmised that the full effects of the LTRO would take time to come through. But contrary to Draghi’s assessment, rising yields could be a signal the full effects have, in fact, already come and gone.

What then?

We suppose, like the Fed’s QE, the ECB will discover that money creation operations are much harder to stop…than to start. Spain depends on it. So does Greece…and Italy, and Portugal, and the entire EU. In other words, the ECB must inflate or die.